Say goodbye to tax-free bitcoins

The Internal Revenue Service issued clarifying guidance on Tuesday, saying digital currencies should be treated like property, meaning purchases and payments must be reported, and the capital gains tax rate can be applied to gains or losses if the currency is considered an asset.

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“[V]irtual currency operates like ‘real’ currency — i.e., the coin and paper money of the United States or of any other country that is designated as legal tender, circulates, and is customarily used and accepted as a medium of exchange in the country of issuance. But it does not have legal tender status in any jurisdiction,” the IRS notice said.

Under the guidance, the IRS ruled any wages paid using bitcoins must reported as regular income and reported on W-2 forms. Bitcoins will also be treated like stocks, bonds, and other investment property when taxpayers calculate gains or losses on capital assets.

That will subject currencies to the long-term capital gains tax rate of 20 percent for top earners.

Bitcoins are created by a complex process known as “mining” where the tech savvy run a series of codes and algorithms to create the currency essentially from thin air. Under the new IRS rules, original miners of bitcoins will be counted in a taxpyer’s gross income.

The ruling applies to all digital currencies, but will have the most impact on bitcoins. The most popular digital currency, bitcoins, were developed in 2009 by a programmer working under the pseudonym Satoshi Nakamoto. It makes up the vast majority of the digital currency economy and has seen prices for each coin jump to more than $500 currently.

Newsweek magazine attempted to out the real Satoshi Nakamoto in a cover story this month saying the founder is an engineer living in California. Nakamoto has fiercely denied he is the created of the currency - a denial that has only added to the mystery surrounding bitcoins.

Many bitcoin users and financial experts have asked the IRS to clarify what the responsibilities currency holders have under tax law.

Sen. Tom Carper (D-Del.), the chairman of the Homeland Security and Governmental Affairs Committee, has been a leading voice in Congress’ effort to clarify how the IRS can tax any digital currencies - saying that the tax-free currencies are contributing to the nation’s tax gap.

“I’ve long advocated for narrowing our nation’s estimated $385 billion tax gap but it’s tough for people to pay their taxes if they have to guess the amount they owe,” Carper said in a statement. “I am pleased that the IRS is taking this important step to provide clarity for taxpayers regarding the treatment of digital currencies. As I’ve said before, the implications for digital currency are wide ranging and demand a whole-government approach. Today, we’ve seen a key agency attempt to put one more piece of the puzzle into place.”

Former Finance Committee Chairman Max Baucus (D-Mont.) and the top Republican on the panel Utah Sen. Orrin Hatch, also asked the Government Accountability Office to study the issue.

Omri Marian, a law professor at the University of Florida and digital currency expert, generally praised the IRS work but said it was unclear on some basic questions.

Specifically, the agency did not dive into how taxpayers can accurately calculate the fair market value, he said.

“Taxpayers will be required to determine the fair market value of virtual currency in U.S. dollars as of the date of payment or receipt. If a virtual currency is listed on an exchange and the exchange rate is established by market supply and demand, the fair market value of the virtual currency is determined by converting the virtual currency into U.S. dollars (or into another real currency which in turn can be converted into U.S. dollars) at the exchange rate, in a reasonable manner that is consistently applied,” the guidance said.

But that doesn’t help as there are numerous establish exchanges where the price of bitcoins can vary by the minute.

“Today for example they varied by $20. Does it mean I have to use the same exchange each time or do I need to pick the highest price for gains and lowest price for losses?” Marian said.

The IRS also didn’t establish how it plans to collect taxes from people who use bitcoins to stay off traditional financial grids. By either “mining” or purchasing bitcoins in cash or from hidden bank accounts, users do not need to have their identify attached to the currency.

Marian said collection could continue to be a problem if the IRS doesn’t consider the privacy tradition in bitcoins.

“A lot of people who participate in the bitcoin community do it for the veil of secrecy,” he said. “I’m not sure how the IRS is going to enforce it when the identities of people are not known.”

A clash of standards may also cause headaches. Germany made bitcoins a legal tender in 2012 and earlier this year exempted the money from its capital gains tax. British authorities said this month they have no plans to impose a tax on trades.